When courts evaluate an insurer's denial of benefits under a group disability insurance policy under ERISA, one of two standards of review applies: abuse of discretion and de novo. The former provides substantial deference to the insurer's decision, making it difficult to overturn. The latter allows the court to review the case anew. Which standard applies makes a big difference.

The abuse of discretion standard can only possibly apply if the group plan contains a "discretionary clause." In order to prevent the negative consequences of the abuse of discretion standard, the California legislature banned the enforcement of discretionary clauses in 2011 through section 10110.6 of the California Insurance Code. The National Association of Insurance Commissioners has had a similar model law on the books since 2004.

Earlier this month, the Ninth Circuit’s newest decision struck a small blow to California's efforts by holding that the ban on discretionary clauses does not apply to fully self-funded employer plans. [1] Importantly, however, the Court affirmed that the law still applies to employer group insurance plans where the benefits are funded by the insurance company. Thus, the critical difference is whether the employer or the insurer funds the benefit payments.

The decision is most likely to affect policyholders on short-term disability through by large employers, as in those cases the employers often fund the benefits themselves. Most long-term disability benefits, even from large employers, are insurer-funded.

The Ninth Circuit's decision here is illustrative. In the case, an employee of Boeing applied for disability benefits under Boeing’s fully self-funded short-term disability plan. Under that short-term plan, Boeing fully funded the benefits payments. Aetna Life Insurance Company, who funded Boeing's long-term disability plan, served as the "plan administrator" for both short-term and long-term benefits. In administering the plan, Aetna initially awarded the employee short-term disability benefits, but later terminated them after determining the employee was not “disabled.” The employee challenged the denial of these benefits and brought suit in federal court under ERISA.

In the District Court, Aetna argued that its termination of benefits should be analyzed under the abuse of discretion standard because the plan had a discretionary clause. However, the district court rejected Aetna’s argument and held that the discretionary clause was void and unenforceable pursuant to the ban. On appeal, the Ninth Circuit held that ERISA preempts section 10110.6 in this particular instance, and thus the discretionary clause was not void. The court reasoned that states are not allowed to regulate employer self-funded plans.

Thus, the decision draws a distinction between state regulation of a self-funded plan and an insured plan. Now, if a plan is “insured,” a state may regulate it indirectly through its insurer and insurance contracts. Conversely, if a plan is uninsured, the state may not regulate it. As a result, employees and other plan participants may endure obstacles when trying to obtain benefits from their employment welfare plans.